Friday, 23 October 2020

The Big Cost to Your Retirement from Small Annual Fees

The Big Cost to Your Retirement from Small Annual Fees
31 May

People like to think of retirement as the time when you get to enjoy a well-deserved rest, but let’s not forget that retirement is also a race between finances and life expectancy. In this high-stakes dash, small investment fees can snowball into budget-devouring amounts over the course of decades.

Take the seemingly insignificant fee charged by the companies that create and manage retirement funds, the so-called expense ratio. A new study from MagnifyMoney reveals how small differences in expense ratios can cost retirees tens of thousands of dollars over the lifetime of their investment, a warning millennials and anyone else who is starting their retirement journey should heed when choosing investments.

In a recent Fidelity survey, 74% of respondents underestimated how much they should save for retirement compared with what financial professionals suggest. This is just one more reason why paying attention to seemingly small fees is a big deal.

Tiny differences in fees have outsized impacts on your savings

To illustrate how much of your retirement savings can be consumed by seemingly small investment and brokerage fees, MagnifyMoney crunched the numbers on two different hypothetical fund investments. The amount invested and the rate of return on both funds was assumed to be the same — the only variable was the expense ratio, which reflects the different management fees for each fund.

In our exercise, one hypothetical fund charges a low annual fee of 0.02% of the total investment balance ($10,000 annual contribution over 25 years), while the other commands an annual fee of 0.99%. While the difference between the fees charged may appear insignificant, the gulf between earnings after 25 years was vast — the fund charging the 0.99% annual fee earned a total of $759,018, while the fund with the 0.02% fee earned $891,142. That’s a difference of $132,124, or approximately 17% of the total earnings on the high-fee fund.

How compounding expenses eat into your returns

Why the yawning disparity between the two earnings totals after 25 years? You might expect the difference in earnings to mirror the gap in the expense ratios, which is 97 basis points.

The answer lies with compounding expenses and opportunity cost. Let’s say you invest $10,000 into a mutual fund with an annual return of 9.0% and an annual expense ratio of 0.99%. After the first year, your investment would generate a return of $900 (0.09 x 10,000 = 900). You now have $10,900, but remember you have to pay the expense ratio. In this case, you have to subtract $107.91 from your $10,900 (.0099 x 10,900 = 107.91) which leaves you with $10,792.09 invested in the fund.

If you leave that money untouched for another year, it would generate a return of $971.29 (0.09 x 10,792.09 = 971.29) and give you a total of $11,763.38. Subtract your 0.99% expense ratio and that leaves you with $11,646.92.

Now imagine you had invested that $10,000 in a different fund that also has a 9.0% annual return but no expense ratio. You still have $10,900 at the end of the first year, but this time you don’t have to take out the 0.99% to pay the fund’s expenses. That means your second year, you are earning a 9.0% return on $10,900 (as opposed to $10,792.09), which gives you $11,881.

Note the difference in earnings between the two funds. It’s not huge after just two years, but the compounding effect over a 25-year period explains the difference in the two hypothetical situations outlined in the section above. Compounding expenses are the reverse of the compound interest effect, by which reinvesting the earnings from savings earns you more and more moneyreinvesting the earnings from savings earns you more and more money. A compounding fee takes a bigger and bigger bite out of your investment over time.

Real world examples: funds tracking the S&P 500

The impact that even a slight difference in a fund’s expense ratio can have on retirement savings isn’t limited to hypotheticals. MagnifyMoney’s study also looked at what would happen if a saver invested $10,000 every year for almost 25 years, from 1994 until 2018, in two of the most popular index-based funds, the Vanguard S&P 500 Index fund (VFINX) and the SPDR S&P 500 exchange traded fund (SPY). For simplicity’s sake, the chart below shows the final four years of our hypothetical investment.

Looking at the historical data, investors in the Vanguard index fund would have approximately $784,300 by the end of 2018, while investors in the SPDR ETF would have about $785,100. If you bought the S&P 500 index (a very challenging proposition for a retail investor, which is why funds like the VFINX and SPY exist in the first place), that same investor would net roughly $798,300, indicating the low expense ratio of the VFINX and SPY funds would only cost investors around $13,000 after 25 years.

Keep in mind, expense ratios have been falling over time. The Investment Company Institute (ICI), an association of investment professionals, recently released a report showing the average expense ratio has declined from 0.99% in 1997 to 0.55% today. That doesn’t mean you can’t find yourself in trouble if you don’t pay attention to a fund’s expense ratio, but it does indicate these costs are shrinking as time marches on.

Should you always avoid funds with high expense ratios?

Your investment strategy needs to reflect your individual goals and willingness to accept risk, but is there any reason to place your hard-earned money in a fund with a high expense ratio?

“In general, you should pick the lower-fee product if you are comparing two investment products that will give you similar asset exposure,” said Josh Rowe, LendingTree’s manager of investments (MagnifyMoney is owned by LendingTree). “The higher the expense ratio, the more ground a mutual fund manager will need to make up to obtain the same return versus a fund with lower expenses, which means that the mutual fund manager will also have to take on additional risk.”

If you’re working with a personal financial advisor, it’s simply a matter of making clear to them that finding funds with low expense ratios are a priority. However, if you are investing on your own, Rowe has some advice on how to find funds with lower expense ratios.

Take a look at the ETFs robo-advisors use by finding that list on the company’s website. “Many robo-advisors actually provide a detailed list of the ETFs that they invest in, often in the ‘White Paper’ section of their website explaining how the robo-advisor works,” said Rowe.

Examine the expense ratios of those funds and, if they’re low enough to your liking, you can buy the ETFs yourself through a self-directed broker and avoid the robo-advisor fee, which is often around 0.25% of your invested balance annually — and robo-advisors charge this fee in addition to an expense ratio. You can also do the same with larger brokers, many of which have lists and screening tools that allow you to only look at low expense ratio funds.

While the importance of a fund’s expense ratio shouldn’t be underestimated, you also need to keep in mind it doesn’t represent the totality of fees you pay for that fund. For example, if you are investing in a fund through a 401(k) or a similar type of employer-sponsored retirement plan, there’s a separate fee negotiated between the employer and the plan providers (the company that actually manages the investments constituting the retirement plan).

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

James Ellis
James Ellis |

James Ellis is a writer at MagnifyMoney. You can email James here


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